Category: Debt

No interest rate changes in 2019?

Take a look at the current snapshot of short-term interest rate futures (for those that do not know how they trade, ZQ is the 30-day Fed Funds rate futures and BAX are the Canadian 3-month banker acceptance rate futures, our closest proxy – the price is 100 minus the implied rate in percentage, so a price of 97.6 would equate to a 2.4% rate):

This creates some interesting financial bets, such as:

1. Do you believe the Fed will continue raising rates?
2. Do you believe the Bank of Canada will raise rates? If so, you can easily bet on this outcome. The next two policy announcements are on January 9, 2019 and March 6, 2019, and the BAX futures imply a very small chance of a rate decrease, but for the most part expect rates to remain the same (i.e. if you bet on the rates not changing you would stand to profit a tiny bit). The current rates as of today are 2.24% (97.76).

Given what has happened in the markets in the past three months, market participants are clearly pricing in that the central banks are going to stop raising rates. In particular, a quarter-point rise in the Bank of Canada rate will completely flatten the yield curve – currently 3-month treasury bill rates are 1.67%, but a quarter point rise will surely take them up to the 2 to 10-year level which are all currently trading around 190-200bps.

These are very strange times indeed.

The question then becomes a bit strange when one puts yourself in the shoes of the Federal Reserve or the Bank of Canada – do you want to raise rates to the point where you will invert the yield curve? It’s a bit gutsy to do so.

The Bank of Canada, as late as their December 5, 2018 policy announcement included the following sentence:

Weighing all of these developments, Governing Council continues to judge that the policy interest rate will need to rise into a neutral range to achieve the inflation target.

Does the Bank of Canada will believe that rates still need to climb to this neutral range?

For reference, the “neutral range” is defined as such:

The neutral nominal policy rate is defined as the real rate consistent with output sustainably at its potential level and inflation equal to target, on an ongoing basis, plus 2 per cent for the inflation target It is a medium- to long-term equilibrium concept For Canada, the neutral rate is estimated to be between 2.5 and 3.5 per cent. The economic projection is based on the midpoint of this range, the same rate as in the July Report.

The January 9, 2019 meeting is thus to be more interesting than most, considering what has transpired since the last meeting – including the Canada-China trade implications on the detainment of the Huawei CFO.

One of the likely implications of the realization of the cessation of rate increases is that there will once again be a chase for fixed income yield. It would probably open the door for more leveraged spread trading (e.g. borrow CAD at 2%, invest at 6% type trading, with the knowledge that the 2% borrow rate will not get more expensive).

The other observation is that the central banks might pause, but if markets start to normalize once again, may continue the tightening bias. Indeed, the Federal Reserve is still implicitly tightening with the reversal of QE and keeping this chart in mind (FRED Data) makes one realize there is a long way to go before things normalize on the Federal Reserve’s balance sheet.

2019 target maturity ETF solutions

I’ve been doing some minor work analyzing low-risk cash parking options in both USD and CAD currency. My underlying assumption is we will see a couple more (quarter point) rate hikes in 2019 if the economy doesn’t crash and we will see nothing happening on rates if the economy does decide to slow down. If interest rates are projected to be less than market expectations, it would make sense to buy a constant-maturity ETF (in particular, NYSE: SHY looks attractive – YTM of 2.85%, duration 1.86 yrs, MER of 0.15%). The following option are fixed-maturity ETFs, which remove most of the duration risk (although in the case of SHY, a duration of 1.86 yrs is not exactly gambling on the direction of interest rates either).

Canadian currency: TSX: RQG – portfolio of high-grade corporate debt, YTM 2.67%, duration about 9 months, MER 0.28%, maturity November 2019.

US currency: Nasdaq: IBDK – portfolio of high-grade corporate debt, YTM 3.05%, duration 0.56 yrs, MER 0.10%, maturity December 15, 2019
Nasdaq: BSCJ – portfolio of high-grade corporate debt, YTM 3.05%, duration 0.58 yrs, MER 0.10%, maturity December 31, 2019

I would deem these ETFs to be relatively low risk – even if there was a meltdown in the corporate bond market. The US ETFs are trading above NAV but market fluctuations should render an execution at par or even a mild discount.

I would, however, avoid the high-yield corporate bond market. Not only will rising risk-free rates damage yields in this sector, but the ultimate risk of investing in high-yield is defaults and it has been quite some time that we have seen the entire junk bond market get hit.

It is also reasonable to construct your own ETF by purchasing the underlying bonds directly. As an example, Shaw and Rogers October/November 2019 debt is roughly 2.7% yield to maturity. All of the ETF names above trade in an efficient and liquid market and it is a lot easier to just trade them instead of the underlying bonds.

Want to make a few pennies? Temple Hotels Debentures

This is a bet on the confidence of your fellow investors to vote against a bad deal.

Temple Hotels (TSX: TPH) is a borderline-profitable hotel operating company. Financially they are in miserable condition. They have mortgages that are in covenant default, loads of debt and other issues (being in the wrong geography at the wrong time).

For whatever reason (still can’t figure it out today), on December 2015 Morguard Corporation (TSX: MRC) decided to take them over (via control of the asset management agreement) and recapitalize the corporation with equity capital through a rights offering. They used the funds ($50 million) primarily to retire about $60 million in convertible debentures in cash. Morguard owns about 56% of Temple’s stock.

Temple still has about $80 million in convertibles outstanding (TPH.DB.E, TPH.DB.F), and $45 million of it is about to mature on September 30, 2017. Yes, that’s in about three weeks.

Looking at their June 30 balance sheet, they have $14 million in cash and the Morguard parent would need to pay up. (I’ll note at this point the busy Canadian summer hotel season will produce about $7 million in operating cash flow, but this is not including mortgage principal payments and maintenance capital expenditures which would bring this figure down a little).

Management, therefore, is floating a proposal to extend the maturity of the debentures 3 years to September 2020. The terms are to keep the interest rate the same (7.25%), decrease the conversion price to something astronomically high ($40.08/share) to something very high ($15/share, or something that’d need to more than triple in order to get at-the-money) and do a 5% redemption at par at the end of the month.

In other words, they are offering nearly zero incentive for debenture holders to extend.

Indeed, management is continuing a practice that the Securities Act should ban, which is the payment to third-party dealers to solicit YES votes in proxies:

Subject to certain terms and conditions described elsewhere in this Circular, the Corporation will pay a solicitation fee equal to $7.00 per $1,000 principal amount of Debentures that are voted FOR the Debenture Amendments, payable to the soliciting dealer who solicits such proxy or voting instruction voted FOR the Debenture Amendments, subject to a minimum fee of $150.00 and a maximum fee of $1,500.00 per beneficial owner of Debentures who votes Debentures with principal value of $10,000 or greater FOR the Debenture Amendments. No solicitation fees will be paid to the soliciting dealers if the Debenture Amendments are not approved by the Debentureholders at the Debentureholder Meeting.

Insiders own 2.49% of the debentures. The vote requires 2/3rds of those voting to pass and a minimum quorum of 25% (which should be attained).

So this becomes a test of whether your fellow debtholders are stupid enough to vote in favour of this agreement or not, and also a function of whether you believe Morguard will back up Temple in the event that this proposal fails. You would think Morguard would provide some debt credit to Temple because otherwise why dump the tens of millions of dollars into the corporation and just have it get thrown away with a CCAA arrangement at this stage? Or have they decided that the salvage operation they are currently conducting is negative value and basically want to throw away this asset?

Since the TPH.DB.E series is trading at 96.5 cents on the dollar, it means that if you bought $1,000 par value you’d be looking at a 3.6% gain in three weeks if the proposal is rejected (it is too late for management to exercise the share conversion option) AND that Morguard gives capital into Temple to pay off the subordinated debt (nobody else would be sane enough to do it without ridiculous concessions).

The risk/reward is isn’t high enough for me to take the risk but I’m floating this one out here for the reader if you are!

KCG, it was good knowing you (Eulogy)

The merger closed yesterday and I received proceeds from the equity and debt today.

The equity I had purchases between $9-11/share. My first stake in the company was back in Q4-2012!

From my debt purchase at 90.5 at the end of June 2016 to 13 months later, resulted in a capital gain of 13.1% plus the 7.6% current yield, made for a 20.7% CAGR investment on a senior secured debt, first in line, on a cash flow positive entity. I’ll miss you.

Bombardier Yield Curve and Preferred Shares

The yield curve of Bombardier continues to compress:

Despite all of the negative press concerning their trade war with Boeing for the C-Series jets, it appears that the credit market is thinking that the credit side of Bombardier is quite secure – offering less than 7% for 8-year money. The company can easily raise capital with its current yield curve.

The preferred shares have had some interesting action lately, and this is because of the repricing of the BBD.PR.D dividend – because of (from the company’s perspective) an ill-timed rapid increase of the 5-year Government of Canada yield curve, their BBD.PR.D series will be giving out 3.983% on a $25 par value of dividends. Around July 10th when the market was blissfully unaware of the dividend adjustment (as they apparently didn’t read press releases), this would have translated into a 10.8% eligible dividend yield.

It is because of this that the BBD.PR.C series has traded down – there is obvious arbitrage between the C-yields and the D-yields. They were originally trading a full 200 basis points away from each other but this has now converged to about 50 basis points which is more reasonable (BBD.PR.C is worth more if you plan on interest rates to decrease, while the D’s are better if you expect them to rise in 4.9 years).

In relation to Bombardier’s bond yield curve, the preferred shares looked extremely cheap (especially the BBD.PR.D series at 10.8% yield!). Now it is around 9.3%.

Disclosure: I own some BBD.PR.C and BBD.PR.D.